Contango vs Normal Backwardation: What’s the Difference?

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Contango vs Normal Backwardation: What’s the Difference?

A futures contract is a derivative that allows traders to buy an asset at the predetermined price. When at contango, a futures contract trades at a higher price than the commodity’s current price. The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a theoretically risk-free profit (see rational pricing—futures). The EU describes the two groups of players in the commodity futures market, hedgers or arbitrageurs/speculators (non-commercial investors). The futures or forward curve would typically be upward sloping (i.e. “normal”), since contracts for further dates would typically trade at even higher prices.

cantango

For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months’ time, 90-day treasury bills will have matured, etc. Backwardation is when futures prices are below the expected spot price, and therefore rise to meet that higher spot price.

2008 world food price crisis

Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity. A contango market is also known as a normal market, or carrying-cost market. Understanding whether a market is in Contango or Backwardation enables traders and investors to make their bets in futures correctly. Derivative is okcoin legit bets undertaken should take into consideration the impact of futures prices accordingly. It enables markets to interpret that the demand for the underlying asset is expected to rise. It also leads to negative rolling returns as futures prices are always higher than the spot prices resulting in rolling costs for each monthly rollover.

cantango

Contango is when the futures price is above the expected future spot price. Contango can be caused by several factors, including inflation expectations, expected future supply disruptions, and the carrying costs of the commodity in question. Some investors will seek to profit from contango by exploiting arbitrage opportunities between the futures and spot prices. As the expiration date of the futures contract approaches, the futures price will get closer to the spot price, irrespective of the futures price being at a higher or lower level. In this case, a trader will sell a futures contract for delivery at $60 while also buying enough barrels of oil at the spot price of $50 to fulfil the order at a later point.

Speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future. They might be able to make even more money by buying futures contracts. However, that strategy only works if actual prices in the future exceed futures prices. In a contango situation, the forward price of a commodity’s futures contract will be higher than its spot price.

About Contango

That’s because, on the maturity date, the futures price must equal the spot price. If they don’t converge on maturity, anybody could make free money with an easy arbitrage. A few fundamental factors such as the cost to carry a physical asset or finance a financial asset will inform the supply/demand for the commodity. This supply/demand interplay ultimately determines the shape of the futures curve.

cantango

Contango is a situation in which the futures price of a commodity is above the spot price. In the case of a physical asset, there may be some benefit to owning the asset called the convenience yield. In the case of a financial asset, ownership may confer a dividend to the owner. At times it may be profitable to hold the tangible commodity rather than holding derivative products in hotforex broker reviews the asset. A contango scenario takes place when the forward price of a futures contract of a commodity is higher than the commodity’s current price, which is why contango is also called forwardation. The company recently formed a new partnership with a subsidiary of Kinross Gold Corporation – The Peak Gold, LLC (Kinross 70% and Contango 30% with Kinross as Manager and Operator).

If today’s cost for the one-year futures contract is $90 , the futures price is above the expected future spot price. Unless the expected future spot price changes, the contract price must drop. If we go forward in time one month, we will be referring to an 11-month contract; in six months, it will be a six-month contract.

Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade, which involved flexible contracts. Convergence is the movement of the price of a futures contract toward the spot price of the underlying cash commodity as the delivery date approaches. An advantage 21 Easy JavaScript Projects for Beginners Code included! Skillcrush of contango would be that it can indicate that the price of a commodity may be higher in the future. Contango may also offer an arbitrage opportunity, which could decline as the futures contract nears its expiration date. Contango, sometimes referred to as forwardation, is the opposite of backwardation.

Each of these gems have been designed in a test driven fashion with almost complete spec coverage so they should be much easier to develop in the future. The old Cantango got too bloated and big and became too hard to maintain in the end. We are making this change to enable us to focus on our core objective of promoting and supporting our investment managers. The value of shares and ETFs bought through a share dealing account can fall as well as rise, which could mean getting back less than you originally put in. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Economic theory

The curves in question plot market prices for various contracts at different maturities — cf. “In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders) to earn a profit.” When the market is in backwardation, the futures prices for the commodity follow a downward-sloping curve in which futures prices are below spot prices. Although backwardation is relatively rare, it does occasionally occur in several commodity markets. Causes of backwardation include anticipated declines in demand for the commodity, expectations of deflation, and a short-term shortage in the commodity’s supply. Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high.

  • Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.
  • “A market is ‘in backwardation’ when the futures price is below the expected spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise to the level of the current spot price”.
  • In 1993, the German company Metallgesellschaft famously lost more than $1 billion, mostly because management deployed a hedging system that profited from normal backwardation markets but did not anticipate a shift to contango markets.
  • In a June 2010 article in The Economist, the argument is made that index-tracking funds did not cause the bubble.

Producers have other reasons to pay more for futures than the spot price, thus creating contango. Producers make commodity purchases as needed based on their inventory. The spot price versus the futures price may be a factor in their inventory management. However, they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time.

Advantages and Disadvantages of Contango

The market will then witness a gradual decline in the futures prices toward the spot prices as contracts get closer to their expiration dates, or an arbitrage opportunity would appear where the price of the contract may suddenly move. In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration. That happens because of the large number of buyers and sellers in the market, which makes markets efficient and eliminates large opportunities for arbitrage.

Contango Meaning, Why It Happens, and Backwardation

Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. Conversely, a market is considered to be in backwardation when the forward price of a futures contract is lower than the spot price of the commodity. A normal backwardation market—sometimes called simply backwardation—is confused with an inverted futures curve.

Consider the appropriateness of the information in regard to your circumstances. Please read the relevant product disclosure statement or offer document and obtain appropriate financial advice before making any investment decisions. With over 40 years of combined experience across business strategy, distribution, marketing, operations and compliance, our high-calibre team promotes and supports a range of strategies across multiple asset classes. In this article, we’ll lay out the differences between contango and backwardation and show you how to avoid serious losses.

Attempting to profit from contango often involves taking risks that are not appropriate for most individual investors. INAV calculations as shown on this website (the “data”) are provided byICE Data Indices, seeICE Terms of Use, and is updated during ASX trading hours. The content in this website has been prepared without taking into account the objectives, financial situation or needs of any particular individual.

A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity. A market is “in backwardation” when the futures price is below the spot price for a particular asset. In general, backwardation can be the result of current supply and demand factors.

For example, using your crystal ball, if you and your counterparty could both foresee the spot price in crude oil would be $80 in one year, you would rationally settle on an $80 futures price. Anything above or below would represent a loss for one of the trading contract pairs. This graph depicts how the price of a single forward contract will typically behave through time in relation to the expected future price at any point in time.

Other costs of carry involve financial, interest and insurance costs. The price difference between futures and spot in contango is mostly related to the cost of carry, which include storing the commodity as well as depreciation costs, and more. An inverted market occurs when the near-maturity futures contracts are higher in price than far-maturity futures contracts of the same type. A futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. In 1993, the German company Metallgesellschaft famously lost more than $1 billion, mostly because management deployed a hedging system that profited from normal backwardation markets but did not anticipate a shift to contango markets. Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely.

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